Underwriting Standards, Actual vs. Stabilized NOI, and Breakeven Analysis (#6 in series)
Q: Why is it important to consider the yield to the investor in underwriting a loan to an income-producing property investor? Is there a value in understanding why the investor is willing to take a riskier investment?
A: An investor in income producing property (IPP) realizes their total return on investment (ROI) in two ways. The first source of return comes in the form of net operating income (NOI) and the resulting cash flow from the rented space. The second source of return is in the form of appreciation in the value of the property.
Many investors speculate on price increases to achieve the yield he or she desires over the recurring rental cash flows. In this situation, the property may suffer from cost-cutting measures intended to improve NOI that may also lead to a decline in the value of the property. This issue may combine with deteriorating market conditions to create further decline in the property’s value. In the face of such declines in value, there is always the possibility that the investor might abandon the property and walk away from their responsibilities on loans supporting the investment. This tendency was widespread and very evident following the 2007/2008 financial crisis and collapse in residential and commercial real estate prices. Many investors that failed to achieve anticipated price appreciation after paying premium prices for an IPP, or were unable to maintain adequate NOI, simply declared default and turned the properties over to the lender. This combination of events burdened lenders with properties that were underwater and were further troubled in terms of generating sufficient NOI to meet debt service.
Q: Do the calculations presented depicting an analysis of return on investment NOT include the cost of interest expense?
A: The calculations do not present a direct acknowledgement of interest expense.
However, interest expense is one of the two debt service components charged to Net Operating Income (NOI) in arriving at cash available for equity investors. The return on investment (ROI) – absent consideration of price appreciation – is cash available for equity investors divided by the amount of the equity investment. In Step 8, recall that cash available for equity investors of $7,915 represented a 0.37% ROI on an equity investment of $2,125,000. The 0.37% ROI – actual NOI of $274,655 reduced by debt service of $266,740 and then divided by the equity investment of $2,125,000 – does indeed take into account the cost of interest expense.
Once we introduced price appreciation into the overall ROI computations, we retained the $7,915 dollar stream from property cash flow available for equity investors, after accounting for interest expense, as one of the two components of ROI.